ESCAPE FROM POTTERSVILLE:
THE NORTH DAKOTA MODEL FOR CAPITALIZING COMMUNITY BANKS

Where can our floundering community banks get the capital to make room on their books for substantial new loans? An innovative answer is provided by the state of North Dakota.

Arianna Huffington just posted an article on the Huffington
Post that has sparked a remarkable wave of interest, evoking nearly
5,000 comments in less than a week. Called “Move Your Money,” the article
maintains that we can get credit flowing again on Main Street by moving our
money out of the Wall Street behemoths and into our local community banks. This
solution has been suggested before, but Arianna added the very appealing draw
of a video clip featuring Jimmy Stewart in It’s a Wonderful Life. In the
holiday season, we are all hungry for a glimpse of that wonderful movie that
used to be a mainstay of Christmas, showing daily throughout the holidays. The
copyright holders have suddenly gotten very Scrooge-like and are allowing it to
be shown only once a year on NBC. Whatever their motives, Wall Street no doubt approves
of this restriction, since the movie continually reminded viewers of the potentially
villainous nature of Big Banking.

Pulling our money out of Wall Street and putting it into
our local community banks is an idea with definite popular appeal. Unfortunately,
however, this move alone won't be sufficient to strengthen the small banks.
Community banks lack capital – money that belongs to the bank -- and the
deposits of customers don’t count as capital. Rather, they represent
liabilities of the bank, since the money has to be available for the depositors
on demand. Bank “capital” is the money paid in by investors plus accumulated
retained earnings. It is the net worth of the bank, or assets minus liabilities.
Lending ability is limited by a bank’s assets, not its deposits; and today, investors
willing to build up the asset base of small community banks are scarce, due to
the banks’ increasing propensity to go bankrupt.

It’s a Wonderful Life actually illustrated the
weakness of local community banking without major capital backup. George
Bailey’s bank was a savings and loan, which lent out the deposits of its
customers. It “borrowed short and lent long,” meaning it took in short-term
deposits and made long-term mortgage loans with them. When the customers panicked
and all came for their deposits at once, the money was not to be had. George’s
neighbors and family saved the day by raiding their cookie jars, but that miracle
cannot be counted on outside Hollywood.

The savings and loan model collapsed completely in the
1980s. Since then, all banks have been allowed to create credit as needed just
by writing it as loans on their books, a system called “fractional reserve”
lending. Banks can do this up to a certain limit, which used to be capped by a “reserve
requirement” of 10%. That meant the bank had to have on hand a sum equal to 10%
of its deposits, either in its vault as cash or in the bank’s reserve account
at its local Federal Reserve bank. But many exceptions were carved out of the
rule, and the banks devised ways to get around it.

That was when the Bank for International
Settlements stepped in and imposed “capital requirements.” The BIS
is the “central bankers’ central bank” in Basel, Switzerland. In 1988, its Basel
Committee on Banking Supervision published a set of minimal requirements for
banks, called Basel I. No longer would “reserves” in the form of other people’s
deposits be sufficient to cover loan losses. The Committee said that loans had
to be classified according to risk, and that the banks had to maintain real
capital – their own money – generally equal to 8% of these “risk-weighted”
assets. Half of this had to be “Tier 1" capital, completely liquid assets
in the form of equity owned by shareholders – funds paid in by investors plus retained
earnings. The other half could include such things as unencumbered real estate
and loans, but they still had to be the bank’s own assets, not the depositors’.

For a number of years, U.S. banks managed to get around this
rule too. They did it by removing loans from their books, bundling them up as
“securities,” and selling them off to investors. But when the "shadow
lenders" – the investors buying the bundled loans – realized these
securities were far more risky than alleged, they exited the market; and they
aren’t expected to return any time soon. That means banks are now stuck with
their loans; and if the loans go into default, as many are doing, the assets of
the banks must be marked down. The banks can then become “zombie banks” (unable
to make new loans) or can go bankrupt and have to close their doors.

The final blow to the easy credit provided by U.S. banks
came with another stricture on capital, called Basel II. It manifested in the
U.S. as the “mark-to-market” rule, which required a bank’s loan portfolio to be
valued at what it could be sold for (the “market”), not its original book
value. In today’s unfavorable market, that meant a huge drop in asset value for
the banks, dramatically reducing their ability to generate new loans. When the
announcement was made in November 2007 that this rule was going to be imposed on
U.S. banks, credit dried up and the stock market plunged. The market did not
begin to recover until 2009, when the rule was largely lifted. However, on December
17, 2009, the Basel Committee announced plans to impose even tighter capital requirements. The
foreseeable result is the collapse of yet more community banks and the drying
up of yet more credit on Main Street.

Anchoring Community Banks to State-owned Banks

Where can our floundering community banks get the capital
to make room on their books for substantial new loans? An innovative answer is
provided by the state of North Dakota, one of only two states (along
with Montana) expected to meet its budget in 2010. North Dakota was also the
only state to actually gain jobs in 2009 while other states were losing
them. Since 2000, North Dakota’s GNP has grown 56 percent, personal income has
grown 43 percent and wages have grown 34 percent. The state not only has no funding
problems, but in 2009 it had a budget surplus of $1.3 billion, the
largest it ever had – not bad for a state of only 700,000 people.

North Dakota is the only state in the union to own its own
bank.The Bank of North
Dakota (BND) was established by the state legislature in 1919
specifically to free farmers and small businessmen from the clutches of
out-of-state bankers and railroad men. Its populist organizers originally
conceived of the bank as a credit union-like institution that would provide an
alternative to predatory lenders, but conservative interests later took control
and suppressed these commercial lending functions. The BND now chiefly acts as
a central bank, with functions similar to those of a branch of the Federal
Reserve.

However, the BND differs from the Federal Reserve in
significant ways. The stock of the branches of the Fed is 100% privately owned
by banks. The BND is 100% owned by the state, and it is required to operate in
the interest of the public. Its stated mission is to deliver sound financial
services that promote agriculture, commerce and industry in North Dakota.

Although the BND is operated in the public interest, it avoids
rivalry with private banks by partnering with them. Most lending is originated
by a local bank. The BND then comes in to participate in the loan, share risk,
buy down the interest rate and buy up loans, thereby freeing up banks to lend
more. One of the BND's functions is to provide a secondary market for real
estate loans, which it buys from local banks. Its residential loan portfolio is
now $500 million to $600 million. This function has helped the state avoid the
credit crisis that afflicted Wall Street when the secondary market for loans
collapsed in late 2007 and helped it reduce its foreclosure rate. The secondary
market provided by the “shadow lenders” is provided in North Dakota by the BND,
something other state banks could do for their community banks as well.

Other services the Bank provides include guarantees for
entrepreneurial startups and student loans, the purchase of municipal bonds
from public institutions, and a well-funded disaster loan program. When North
Dakota failed to meet its state budget a few years ago, the BND met the
shortfall. The BND has an account with the Federal Reserve Bank, but its
deposits are not insured by the FDIC. Rather, they are guaranteed by the State
of North Dakota itself - a prudent move today, when the FDIC is verging on
bankruptcy.

A New Vision for a New Decade

A state-owned bank has enormous advantages over smaller
private institutions: states own huge amounts of capital (cash, investments, buildings,
land, parks and other infrastructure), and they can think farther ahead than
their quarterly profit statements, allowing them to take long-term risks. Their
asset bases are not marred by oversized salaries and bonuses, they have no
shareholders expecting a sizable cut, and they have not marred their books with
bad derivatives bets, unmarketable collateralized debt obligations and
mark-to-market accounting problems.

The BND is set up as a dba: "the State of North
Dakota doing business as the Bank of North Dakota." Technically,
that makes the capital of the state the capital of the bank. The BND's return
on equity is about 25 percent. It pays a hefty dividend to the state, projected
at over $60 million in 2009. In the last decade, the BND has turned back a
third of a billion dollars to the state's general fund, offsetting taxes.

By law, the state and all its agencies must deposit their
funds in the bank, which pays a competitive interest rate to the state
treasurer. The bank also accepts funds from other depositors. These copious
deposits can then be used to plow money back into the state in the form of
loans.

Although the BND operates mainly as a “bankers’ bank,”
other publicly-owned banks, including the Commonwealth Bank of Australia, have
successfully engaged in direct commercial lending as well. This has proven to
be a win-win for both the borrowers and the government. The public bank model also
offers exciting possibilities for refinancing the state’s own debts and funding
infrastructure nearly interest-free. For a fuller discussion, see “Cut Wall Street Out! How States Can Finance Their
Own Recovery.”

For three centuries, the United States has thrived on what
Benjamin Franklin called “ready money” and today we call “ready credit.” We can
have that abundance again, by generating our own credit through our own state
and local banks. Just as George Bailey needed a visit from an angel to point
the way, so we just need the vision to see the possibilities.

Arianna’s vision for moving our money from the large banks
into our local community banks is a very admirable first step. However, those
community banks are not likely to have sufficient capital to free up credit for
their local businesses and other customers without the partnership of state-owned
banks, or the publicly-owned banks of counties and larger cities, which also
have ample capital assets. A number of states, counties and cities are actively
exploring this option. The BND model shows us how government-owned banks and
community banks can work together to get money flowing back to Main Street
again.

Ellen Brown developed her research skills as an attorney
practicing civil litigation in Los Angeles. In Web of Debt, her latest
book, she turns those skills to an analysis of the Federal Reserve and “the
money trust.” She shows how this private cartel has usurped the power to create
money from the people themselves, and how we the people can get it back. Her
earlier books focused on the pharmaceutical cartel that gets its power from
“the money trust.” Her eleven books include Forbidden Medicine, Nature’s
Pharmacy (co-authored with Dr. Lynne Walker), and The Key to Ultimate
Health (co-authored with Dr. Richard Hansen). Her websites are www.webofdebt.com and www.ellenbrown.com.